Board Leadership: When Looking at Financials, Don’t Do What Seems Most Obvious

In the nonprofit sector, we’ve gotten used to complexity when it comes to assessing the performance of our organizations. An organization’s “effectiveness” can be a complex combination of benefits to constituents, social and political impact, cost efficiency, and even environmental footprint.

With all of that complexity, it would at least be nice if nonprofit financial statements — and “bottom line” performance, at least in the financial sense — were perfectly straightforward. Unfortunately, there’s some complexity there, as well.

And those executives or board members who are used to looking at standard corporate (or even personal) financial reports can often misinterpret this key metric of nonprofit performance and sustainability.

The source of confusion is apparent anytime you pick up a set of audited nonprofit financials and turn to the Statement of Activities. Typically, what you’ll see there is a grid-type presentation showing columns called “unrestricted,” “temporarily restricted,” and (sometimes) “permanently restricted” — each with their own “bottom lines” — as well as a “total” column.

“Whew,” you think, “I don’t know what all of this other stuff means, but at least I know that total means total, so the bottom line in the total column should tell me how this organization is doing financially.”

That’s a perfectly rational and even obvious assumption to make. Unfortunately, it’s also incorrect.

Without getting too technical, when revenue appears as “restricted” on a nonprofit financial report, it means it’s been designated by a donor for some future use (or, in the case of permanently restricted funds, preservation), rather than being available for use in the period the report covers. It’s money an organization has been given but hasn’t yet been allowed to spend.

What this means is that we can really only compare the unrestricted portion of income to expenses in order to understand the actual operating results — the true “bottom line” — of a nonprofit organization.

When teaching this concept, I sometimes say that the Statement of Activities’ “unrestricted” column compares an organization’s available revenues for a year to expenses that year, the “temporarily restricted” column tells us the revenue raised that year for use in future years, and the “total” column was put there to confuse us.

OK, it wasn’t actually put there to confuse us (there are technical reasons why it has to look like this), but by combining revenue intended for use in different periods and comparing that with expenses from a single period, confusion can be a pretty common result.

To illustrate, let’s look at an excerpt of a Statement of Activities below:

Looking at this in the “obvious” way, it seems to show an organization that broke even in 2016 — $2 million in total revenues, $2 million in total expenses. But if we look more closely, we see that only $1,750,000 of those revenues were “unrestricted”—in other words, available for use in 2016.

The organization carries forward an additional $250,000 (net) in revenue intended for use in future years, shown here in the “temporarily restricted” column. So the $2 million in total revenue is something of a mirage — $250,000 of it really is for use in 2017 and beyond.

That’s not a bad thing in itself — it will go to offsetting expenses in those years, but it’s not a help to the 2016 operating results, which are not in fact break-even but a $250,000 deficit. This means $250,000 has been depleted from the organization’s financial reserves, potentially threatening financial flexibility and sustainability.

A brief but important technical note: take a look at the line called “Net Assets Released from Restrictions.” That $200,000 “transfer” means that the organization met the terms imposed by donors for the use of $200,000 in restricted funds. That line will always show a zero in the “total” column — it’s just a transfer from the restricted to the unrestricted column — but it still has a big impact on the unrestricted bottom line, so it’s important to understand.

Organizations need to keep a close eye on what is moving from restricted into unrestricted in order to be able to anticipate operating results. Unfortunately, this can get even more challenging when we’re looking not at audits but at standard internal financial reports.

In a basic accounting system like QuickBooks, reports such as a profit-and-loss are presented on a “total” rather than an “unrestricted” basis. This can be the cause of some unfortunate surprises at the end of the year, when an organization’s leaders have been looking at reports that show positive or break-even results that suddenly turn into a deficit when the restrictions get sorted out. That’s why it’s important to monitor and forecast our unrestricted financial results not just at audit time but regularly throughout the year.

Lots of nonprofit leaders and board members get caught by doing what seems perfectly obvious — looking at a “total” bottom line — and miss much of the real story of what a financial statement is telling.

To know a nonprofit’s true financial performance, we have to look in a not-so-obvious place: unrestricted results.

Hilda Polanco is the Founder and CEO of Fiscal Management Associates, the go-to advisor foundation and nonprofit leaders seek when addressing nonprofit financial management capacity. Hilda provides capacity building, training and coaching services to foundations and nonprofits throughout the country.